Is the Federal Government Broke? Posner

A company or other organization, or an individual, is insolvent when its liabilities (what it owes) exceed the market value of its assets. Bankruptcy is a legal mechanism for liquidating or reorganizing an insolvent entity in a way that maximizes value for the creditors. When a firm is insolvent, each of its creditors is eager to be repaid what he is owed, out of the firm’s assets. By definition those assets are insufficient to satisfy all the creditors’ claims, so the creditors race to obtain judgments, which are then satisfied by sale of the firm’s assets, perhaps at fire-sale prices because of the race. Even if the firm could be saved as a going concern by eliminating some of its debt burden (its liabilities), transaction costs will make it difficult for the creditors to agree on how far their respective claims will be written down—how in short to share the grief. In a bankruptcy proceeding, the creditors are barred from suit and the judge supervises an orderly disposition of assets (whether by liquidation or by placing them in a reorganized entity) designed to maximize their value and hence the creditors’ ultimate return.

 

Bankruptcy is not limited to individuals and business firms; under U.S. law, even a city can be declared bankrupt; and this happens occasionally. In one Illinois town, the bankruptcy judge ordered the sale of city hall to satisfy creditors’ claims. U.S. states cannot be subjected to bankruptcy proceedings, and neither can the federal government, or the governments of other nations. But that doesn’t mean that a state or nation can’t be insolvent. Insolvency is the condition; bankruptcy is a method of treating the condition.

 

A nation has creditors in both a narrow and a broad sense. In the case of our federal government, they are of four types: owners of federal securities (Treasury bonds and short-term bonds called Treasury bills or Treasury notes); other persons or firms that have contracts with the federal government, for example for sale of goods or services to it; holders of federal entitlements, such as social security, Medicare, Medicaid, and the pensions of retired federal employees; and beneficiaries of government services (as distinct from transfer payments), such as drivers on interstate highways and visitors to national parks, as well as the population at large, which is protected from crime and foreign aggression by federal police and military forces.

 

The first two categories of holders of government “debt” in a broad sense—owners of government bonds and holders of government contractors—correspond closely to the creditors of private companies. The third does not because federal entitlements can always be cut with impunity, from a legal standpoint; and the fourth are not entitlements, but services that are funded by annual congressional appropriations and so can be altered without being thought to disrupt settled expectations; they are the domain of “discretionary” government spending, though in a legal sense entitlements are discretionary also rather than being fixed and legally enforceable obligations.

 

But remember that insolvency is the condition, bankruptcy merely a treatment for the condition; and a condition is not less grave just because the best treatment for it is unavailable—in fact the condition is more serious in that case.

 

These reflections are suggested by the first issue (August 25) of a new publication by Morgan Stanley called Sovereign Subjects. The first issue is captioned “Ask Not Whether Governments Will Default, but How.” It is a criticism of the conventional method of evaluating a nation’s economic condition, which is to compare public debt (government bonds) to Gross Domestic Product. In the case of the United States, that ratio in percentage terms is 53 percent, which is high by historical standards but lower than that of a number of European nations, which are listed in the report (France, Germany, Greece, Ireland, Italy, Portugal, Spain, and the U.K.). But as the report points out, this is not a proper way to determine solvency. The proper way is to compare assets and liabilities. The major asset of any government is its taxing power, which of course cannot be equated to the entire GDP, or the entire value of the nation’s human and physical capital; for both economic and political reasons, the taxing power is limited to a percentage of GDP well below 100 percent. And, realistically, the liability side of the national ledger includes not only government bonds but also other contractual obligations, entitlements, and at least strongly anchored expectations concerning government services (we’re not about to eliminate our armed forces). In addition, as especially emphasized in the Morgan Stanley report, the national balance sheet must be reckoned in dynamic terms, with due regard for likely increases both in GDP and in liabilities, especially increases in entitlement spending that are likely to result from the continued ageing of the population.

 

Because American tax rates are low by international standards and resistance to increasing them is fierce, Morgan Stanley’s report estimates that the ratio of current U.S. public debt to realistically realizable tax revenues is 3.58 to 1, which is the highest by a large margin of the countries in the report’s list; only Greece comes close (3.12 to 1). But America has certain advantages, such as a younger population and a more rapid rate of economic growth, and as a result its ratio of net worth to GDP is in the middle of Morgan Stanley’s list of countries—but it is strongly negative, as are the ratios of all the countries in the list (Italy, surprisingly, being at the top, and Greece, unsurprisingly, at the bottom). According to Morgan Stanley’s calculation (which obviously is merely suggestive, as the report emphasizes, because of the uncertainty of the future), America’s net worth is negative, and this negative net worth is eight times larger than our GDP. This means that the net present value of the government’s liabilities, minus assets, is approximately $120 trillion.

 

What does a firm or an individual do when it is broke and there is no bankruptcy regime? It defaults. Nations do occasionally default on their bonds or other contractual obligations; or, if the bonds or other obligations are denominated in the local currency, they inflate the currency and so repay their obligations in cheaper money, which is the equivalent of a partial default. The U.S. government is unlikely to do either of these things and therefore, in conventional parlance, is not insolvent. But as the Morgan Stanley report insightfully emphasizes, the government has other “stakeholders,” and they are creditors in a loose but illuminating sense. A cut in social security, Medicare, or other entitlements amounts to breaking the government’s promises to the holders of these entitlements, promises on which the holders have relied. So does reducing government services (highways, police, etc.) or increasing taxes, which reduces the net value of those services.

 

The deeper the financial hole that the government has dug for itself by incompetent economic management—and our government has dug itself a very deep hole, largely because of the mismanagement of monetary policy and financial regulation by the Federal Reserve under Greenspan and Bernanke and by other government agencies—the more difficult it is to climb out of the hole on the backs of holders of entitlements and recipients of government services. The political resistance is too intense. It’s at that point that the bondholders, and holders of other contractual rights against the government, have to start worrying about the prospects for outright default or default through inflation. These are possibilities in our future, just as in the future of Greece.

Comments

[Joshua Norman]

@ M Hoffman

Did you know you shared the same first initial and last name as Michael Hoffman the Holocaust denier?

Jewish bankers & trillion dollars for wars for Israel? I think you forgot to take your meds today. Please put your tinfoil hat back on so they won't scan your brain waves, though I think you lack the proper equipment for them to do that.
Plus no one forced El Republicano Caudillo El Presidente Jorge Wahhabi Bush to invade Afghanistan or Iraq. Presidente Bush was El Decidir. I think he did it because he didn't want to invade Saudi Arabia, a country where his family has ties to and the country when 15 out of the 19 hijackers hailed from. As for Israel's "foreign aid" Israel only receives $2.3 billion annually and they have to use it to buy weapons from American contractors. That's not fair, given the opportunity Israel could learn to blow as much on their military industrial complex as the US does instead of having to spend it in America. BTW I oppose foreign aid, even for democratic allies like Israel. I oppose it for Israel because the US has too much leverage over Israel if Israel turned down military aid the US can't tell them to surrender land.

If only there was an ounce of truth in your ranting, maybe then Israel wouldn't have to deal with Barack Hussein Obama, the long-legged Muslim Mack Daddy trying to get Israel to surrender to the Arab Muslim Nazis.

[James Morgan - Puritan Financial Advisor]

The political resistance is too intense. It’s at that point that the bondholders, and holders of other contractual rights against the government, have to start worrying about the prospects for outright default or default through inflation. These are possibilities in our future, just as in the future of Greece.

[Henri Labelle]

Thanks a lot for this very complete article! I agree with your position.

[Douglas Levene]

Judge Posner's analysis is trenchant as usual.

A question he does not address is what happens if a state is insolvent. States cannot print more money so they can't inflate their way out of debt. There is no legal process in place for the adjustment of debts owed by a state and it's far from clear that creditors could levy on state-owned assets to pay off defaulted state debt. Can a state constitutionally enact legislation providing for all state debts to be reduced proportionately as part of restructuring of state obligations? Who knows? I suppose a defaulting state would end up like Argentina when it went bust, unable to borrow any money at all, and living solely on the proceeds of state taxes and the generosity of the taxpayers of the other states via the Federal government, until such time as it could negotiate a voluntary restructuring with the debt-holders.

[mba]

Interesting article. You make some good points. Thank you again.

[sevisme]

I live by the assumption that the answer is yes.

[Debt Advice]

Good info, I do think they are currently like paper trying to wrap over fire right now. You sure can't hide it!

[william Hayes]

I agree with Becker that, policies which promote investments in total factor productivity growth produce long-term economic growth. Still, everyone always ignores relative ROI. What if, as history suggests, the ROI on government 'investment' and spending is much lower than that of private sector or, more markedly, venture capital investment? If that is the case, than any government policy which 'increases TFP growth and long term economic growth' actually decreases it relative to hypothetical private sector base line. This, for the future is impossible to prove, but the vast preponderance of historical data suggests that it is the case, including detailed recent studies by Harvard Professor Dr. Lerner

[Alex]

Deficits are not a problem. They can be simply wiped out through international cooperation.

If governments worldwide simply start taking a lot of money from highly productive people, wealthy savers and investors and then distribute it to average people then …

You simply have the curious phenomenon whereby all of humanity all of a sudden starts being able to afford and enjoy a lot more goods and services without humanity actually having to produce more goods and services. Voila! The perpetual machine of prosperity! If we could only believe in “hope and change” it would actually be possible…
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Is the U.S. Government really unlikely to inflate its currency?

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I agree is lack of confidence, lowering standard of living and social disintegration. Not to mention inability to execute foreign policy. One consequence of any remedial choices considered will be everyone being equally poor. Finally the equalitarians will have what they want. Even worse, because of their inability to monetize debt, the cities. I do fear that we are attempting to over-leverage whatever governmental or public equity we have. I also doubt that the market for federal debt is so irrational and/or inefficient that the Treasury can continue to issue mountains of debt at low interest rates unless investors recognize the the federal government is not insolvent.

[Arjun]

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and for goods and services. Monetizing the debt will occur in any event. Who now benefits from this "economy"? The Jewish bankers and Federal Reserve banks who control the "money supply". Recently the Fed has been purchasing treasury debt in large quantities. This is a no lose proposition since the money which the government could create at nominal cost is instead "borrowed" from the Fed which also creates the "money" at nominal cost. Can the banker in Monopoly go

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